WSJ Headline Economic Gauge - Sense of Optimism Balanced with the Realities of the Marketplace

As we enter 2010, there is an increased amount of optimism about our economy and middle-market M&A activity being expressed by many of the people I talk with – business owners, middle-market focused private equity and sub-debt professionals, other investment bankers, lenders as well as other advisors to middle-market companies. I think that this optimism is driven by pent up demand – company owners who have been waiting for a year or more for the economy to improve and now, realizing this may be the new normal, they are adjusting to a new reality of lower valuations; company owners who are in a position to acquire less well capitalized competitors whose owners are fatigued from dealing with an uncertain economy; private equity firms with lots of capital to invest; and foreign and domestic strategic investors who have largely been on the M&A sidelines dealing with their own strategic issues.
 
Since our November 11, 2009, report that our WSJ Headline Economic Gauge showed a positive indication for the month of October – 49% Positive to 42% Negative, the Gauge leveled out for November – 43% Positive and 43% Negative, and turned heavily to the negative for December – 28% Positive to 51% Negative; however, with 21% Neutral – the highest level in the Neutral category that we have seen, I conclude that the high level of Neutrals moderates the Negative to Positive ratio so that the economy is not really as bad the December Gauge might indicate on the surface. We look forward to continuing to follow the Gauge and reporting through 2010.
 
Month----------Positive-------Neutral--------Negative-----Total Headlines
March-----------18/26% ---------6/9% ---------45/65% -----------69
April------------40/32% --------13/10% --------71/51% ----------124
May ------------50/23% --------37/17% ------131/60% ----------218
June ------------50/40% -------15/12% --------61/48% ----------126
July -------------76/35% -------26/12% -------113/53% ----------215
Aug -------------31/42% --------11/15% --------31/42% -----------73
Sept-------------49/38%----------9/7%----------72/55%-----------130
Oct---------------94/49%--------16/8%----------81/42%-----------191
Nov------------- 51/43%--------17/14%---------51/43%-----------119
Dec--------------34/28%--------26/21%---------62/51%-----------122
 
The nascent sense of optimism, though, needs to be balanced with some of the realities of the marketplace, namely: underemployment, lack of available debt for many small and middle-market companies, a continuing shaky housing market, and the abysmal shape of most state and municipal finances. In fact, The San Francisco Business Times reported in its January 1-7, 2010, edition that nearly 7 in 10 SF Bay Area business owner respondents to its annual December poll on the economy said that they have seen no sign of recovery; and less than 1 in 10 said they are fully through the downturn.
 
Underemployment
Recent reports have indicated that the rate of increase in unemployment is slowing with “only” 85,000 jobs lost in December; however, with that number the WSJ (Saturday, January 9-10) reports that in December 2009, there were 7.2million fewer jobs than in December 2007. The WSJ article continued that the unemployment rate remained at 10% BUT only because many workers stopped looking and were not counted; and that underemployment – including those who have quit looking for jobs or are working part time – is hovering at in excess of a staggering 17%. Just to keep up with normal population growth, the economy needs to generate 100,000 new jobs per month. It seems clear that we have a long way to go before the economy moves from reducing the rate of increase in unemployment to true reduction in unemployment. And until that happens, the consumer is going to be hesitant to increase spending resulting in a continued drag on the economy.
 
Lack of Availability of Debt
For the third quarter of 2009, Federal Reserve data showed that debt outstanding to small and middle-market businesses was off by about 10% - bank debt and all other forms of credit except owners’ net investment. Ask any business owner and he will tell you that most bank debt and particularly inventory financing has been reduced even for companies that are long-standing bank customers, in some cases reduced significantly. It is a fact that the volume of bank loans to small and middle-market companies has been reduced and new loans are increasingly difficult to obtain. For the banks, their over-riding issue is trying to maintain strong balance sheets in the face of rising delinquency rates for commercial mortgages. The WSJ on January 8, 2010, reported that 6% of commercial mortgage borrowers in the U.S. have fallen behind in their payments. The article quoted Jefferies & Co. saying that by year’s end, delinquency rates on loans for hotels, shopping malls and other commercial properties could rise to between 9% and 14%.  It is not clear whether banks are facing up to the full extent of losses on the books as the practice of “amend and extend” may be concealing the true level of problem loans. But they do not want to foreclose on those potentially bad loans so they have little choice. And those potential problems for their balance sheets make it almost impossible for them to lend to even moderately qualified borrowers. I don’t see bank lending returning to pre-recession levels for some time to come.
 
Shaky Housing Market
Year-end data showed some signs that the housing market was stabilizing; however, a continuing flood of foreclosures – some estimate as many as 1.7 million in the next several months - and the eventual end of government support threaten that trend. In fact, many would argue that most of the rebound in existing home sales has been driven by the government’s tax credit for first time home buyers. With government subsidies coming to an end, many are expecting a drop in sales. Additionally, with a large and increasing inventory of foreclosed homes as a result of the unemployed and underemployed struggling to keep up on mortgage payments, it seems that a true and sustainable housing recovery is a long way off.
 
State and Municipal Finances
The SF Chronicle reported on January 17, that “the sharpest decline in state tax revenue on record is hammering 48 out of 50 states”. The result is that states and municipalities are slashing expenses across the board including lay-offs in all categories – K-12 education, higher education, transportation, public health, public safety and other state and municipal employees – and raising revenues any way they can. These large spending cuts and tax increases are deepening the recession and these budget problems are expected to persist through at least 2012! The Chronicle reported that the Center on Budget and Policy Priorities estimates that the current states’ budget gap is at nearly $100 billion and will grow to $180 billion as revenues continue to fall. We have not yet felt the full extent of these problems and there are no easy solutions.
 
So, what does all this mean for middle-market companies? With the many continuing pressures on the economy and a true recovery still a ways off, business owners must explore alternatives to traditional bank financing for both working capital and for growth; they must make sure their balance sheets are strong so that they will be able to sustain their business in these challenging times; and they must make sure they are managing their companies as efficiently as possibleby considering new or different ways of operating the business.
 
It also means that there are opportunities: acquire vulnerable competitors at attractive valuations; take on institutional financial partners who can help to improve balance sheets - commercial finance companies, subordinated debt providers or private equity firms; consider a sale to a domestic or foreign strategic Buyer; or seek partial or full liquidity by attracting a private equity investor.
 
Particularly in these uncertain times, it is important to engage professionals who can assist middle-market company owners in considering the numerous options that are available to help achieve their goals. We at Barnard/Montague Capital Advisors would welcome the opportunity to work with company owners and/or their advisors to explore debt and equity financing or M&A opportunities.
 
To learn more about our services, please take a look at our web site at www.BarnardMontague.com.